October 2nd Should Be Boring (Unless the CFTC Kills Electronic Trading)

On October 2 the CFTC’s swap execution facility (SEF) rules are scheduled to finally take effect. It’s amazing that we’ve finally gotten to this point, given I wrote my first piece about SEFs in 2010, a few months after the signing of Dodd-Frank. While the day is technically historic, don’t expect to anything exciting to happen.

The obvious reason for the lack of excitement is that having the SEF rules in place means only that many-to-many platforms offering electronic and voice swaps trading must be registered as a SEF and be in compliance with all parts of the SEF rule (prevent fraud, have a chief compliance officer, and so on). It doesn’t mean that market participants must start using SEFs. And, while central clearing gave market participants the immediate benefit of reducing counterparty risk, SEFs don’t provide much economic incentive to prompt swaps users to voluntarily begin trading on them. Even if liquidity and pricing eventually improve on SEFs (a debatable point), that will not occur on Day 1 or Day 10, ensuring trading will largely carry on as is until trading on SEFs becomes mandatory.

And that won’t happen until made available trading (MAT) rules take effect, for which the earliest theoretical date is December 18th. But it is highly unlikely the CFTC will implement such a major change the week before Christmas. This has driven market consensus toward Q1 2014 as the target for mandatory SEF trading.

On to the more nuanced reasons October 2 should be boring. “Footnote 88” states that all multi-lateral trading in all swaps, as defined by the CFTC, must occur on SEFs. This means that even platforms trading in swaps that are not yet mandated for clearing must register as SEFs and comply with all SEF rules. While it might sound like a good thing to ensure all swaps trading on SEF-like platforms are overseen by the CFTC, it’s just not that simple. Rather than driving more trading to SEFs, Footnote 88 will drive buy-side firms away from electronic trading and back to the phone.

Dealers are looking for relief beyond Footnote 88. For example, more time is being requested to execute the huge amount of legal paperwork required to get everyone ready to begin trading on SEFs. Each SEF has a completely separate rule book for example, each requiring review and signoff. That said, I do not expect the CFTC to be particularly sympathetic to this hardship, as in their eyes the market has had plenty of time to prepare. I do however expect them to provide relief on Footnote 88 – a rule that would effectively de-electronify the market, a stark contrast to the ultimate goals of the Dodd-Frank Act.

If Footnote 88 keeps its current form, October 2 will in fact be a big day: Trading will dramatically move off-screen, creating a tremendous workload for junior traders forced to book manual tickets for orders done over the phone. Products such as non-deliverable forwards and foreign exchange options will get hit particularly hard, as will trading in the interdealer market, making it nearly impossible for the market’s liquidity providers to hedge risk.

I don’t own a crystal ball, but given the multiple previous CFTC swap-related rule implementations, it’s reasonable to assume that the CFTC will provide no-action relief on this rule and others that would disrupt the market in the short term. (DISCLAIMER: Don’t take this as legal advice; it’s just my opinion.) Expect such CFTC moves to make some fireworks the day or two before October 2, as this kind of relief often posts in the eleventh hour before the rules are set to take effect which leaves little time for the market to react; better late than never, I guess. Reason does not always come in to play when it comes to derivatives regulatory reform however. If I turn out to be wrong on this point, the CFTC will have successfully de-electronified the market in stark contrast to their ultimate goals.

Under the best case scenario, October 2 will serve as a starting gun for market participants to truly begin preparing for the move to the screen. The process entails not only kicking the tires of the registered SEFs, as has been the case for the past several months, but actually connecting and putting trades through the chosen platforms to ensure the process works and that everyone from the PM to the trader to the back office understands it. Such testing will generate some trading (and a lot of press releases, I’m sure), but the proverbially switch will not flip until two or three weeks before mandatory trading begins. Waiting until the days before the mandate is ill-advised, as SEFs and dealers will find themselves hugely backlogged by then. Some buy-side firms got burned by their procrastination in the days before the clearing mandates took effect, losing access to swaps markets for a period of time.

This also means that trading volumes in the first days and months will have little to do with which platforms are ultimately successful. No one should be ruled out (or in for that matter) until well after MAT rules are in place and trading on SEFs is required.

But in the coming days, despite the “no relief” message coming out of Washington, let’s hope the CFTC does what they need to do to ensure an orderly transition to the new, electronic, regulated world and not take us 10 steps backwards to go one step forward.